Short Termism Hits Berkshire (Or Does It?)


We couldn't help but snicker a bit at the news, reported via Bloomberg, that Berkshire Hathaway CDS costs have "almost tripled in two months." Bloomberg attributes the soaring CDS quote to a series of equity index puts Berkshire wrote some time ago. The puts have attracted a great deal of attention almost since their original sale, partly because of Buffett's often quoted (and seemingly hypocritical) analogy putting derivatives in the "financial weapons of mass destruction" category. (We picture Brooks Brothers clad Femmebots holding suitcases filled with cash and shooting fire from their perfectly shaped breasts while intoning "Here's your liquidity. Here's your liquidity." in robotic-monotones).
As far back as February, Barron's suggested that those puts could show losses as high as $2 billion in the third quarter. Their near $7 billion paper liability at present would be a painful surprise to anyone relying on Barron's estimates, if the puts were really capable of inflicting much pain on Berkshire at this point. They aren't.

In some way, Buffett's genius (to the extent it exists) is not directionally perfect trading, not calling the top or the bottom, but cutting amazing deals that no one else would likely ask for, much less get, outside of the "covenant lite" days of LBO lending.
In Buffett's shareholder letter from 2007, he discussed the instruments:

These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at year end of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.
Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire's balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.
Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings - even though they could easily amount to $1 billion or more in a quarter - and we hope you won't be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

These are anything but standard option contracts. When the deal was cut, Berkshire had written European style put options, penned at then at-market strikes with 15-20 year expiration dates, with very restricted margin call requirements. Apparently, mark-to-market or fair value accounting adjustments don't trigger any requirement for Berkshire to post additional collateral. Though the text of the contracts are not public, it seems that only Berkshire credit downgrades would trigger collateral requirements.
If these facts are correct, Berkshire has, therefore, managed to obtain the use of $4.5 billion in cash and will pay nothing between now and 2019 unless it faces a severe credit downgrade, and will pay nothing after 2019 unless three equity indexes including the S&P 500 are trading lower than their 2004-2006 levels. To put it in perspective, the S&P 500 would have to be trading at under 300-500 today for similar puts to expire in the money. In a way this looks like writing CDS protection on Treasury instruments. If they actually come due you have problems so much more significant than paying the put off that you wonder if you are ever going to have to come up with the cash (rather than find a sharper stick with which to stab the rabid tiger that has escaped the local zoo and feed your warrior clan for the next week in order to be strong enough to fight off roving bands of the Lord Humongous).
Also, and not to put too fine a point on it, will the Sage even be around when these come due?
Berhshire's five year average return on equity floats around 10.5%. This isn't a perfect return number to apply, and even the Sage admits he can't continue the outstanding returns he is famous for, but $4.5 billion with that kind of a return over 15-20 years should fetch between $20 and $33 billion.
In short, it's hard to understand why CDS protection would spike like that over a non-cash derivative liability's short term swings. Or, maybe, CDS traders are looking at something else all together more sinister. Berkshire also has written a number of CDS contracts, though their notional amount is substantially lower. Bloomberg doesn't delve into these in detail, but they also think that the fact that Barack Obama seeks Warren out for economic advice is a reason to think that the puts will expire worthless, so who knows what the hell they are thinking.
Berkshire's Credit Risk Soars on $37 Billion Bet [Bloomberg]